Tag: tenant in common

Beware of Phantom Income

Real Expenses vs. Phantom Expenses

As a real estate investor, it is essential to know the difference between a real expense and a phantom expense. An investor might think a $1,000 roof repair is a good thing since he or she can deduct it as an expense. What if you never had to make that repair in the first place? You would have $1,000 of taxable income in your pocket. Being taxed isn’t automatically a bad thing, since that means you are making money on the property.

real estate and phantom incomeWhat is a Phantom Expense?

Depreciation is the perfect example of a phantom expense since it allows an owner of real estate to recover the value of the building against rental income. The IRS allows a deduction for the decrease in value of your property over time, irrespective of the fact that most properties never really wear out. Simply put, depreciation allows you to write off the buildings and improvements over a prescribed period of time, providing a “phantom expense” that is used to offset rental income.

Residential real estate and improvements are depreciated over a 27.5 year period. Commercial real estate and improvements are depreciated over 39 years.

Debt Amortization

In addition to a depreciation deduction, the Internal Revenue Code allows for the interest portion of a mortgage payment to be deducted for income tax purposes. The principal portion of a mortgage payment is treated as taxable income or “phantom income“.

During the initial years of a typical mortgage loan, the principal reduction (debt amortization) is normally offset by depreciation deductions and interest expense, decreasing taxable income. In the later years of a typical loan amortization, principal reduction will exceed interest expense and depreciation, thereby increasing taxable income and generating a seemingly disproportionate tax liability (the dreaded phantom income).

Disposition of a Property

A taxpayer may incur phantom income upon disposition of a property. Phantom income is triggered when taxable income exceeds sales proceeds upon the disposition of real estate. Usually, this results from prior deductions based on indebtedness. You may have deducted losses and/or received cash distributions in prior years that were greater than your actual investment made in the property. If you are planning to dispose of a property and believe you are in this situation, there are strategies to minimize the tax impact including IRC 1031 exchanges, which are discussed in my blog Understanding IRC Code Section 1031 and why you should care.

Real estate investors who want to maximize their after tax cash flow need to be cognizant of phantom income and compare their cash flow to taxable income. This analysis should be undertaken regularly as it may impact their investment returns. If you have questions about phantom income and your real estate, contact me at [email protected] or 201.655.7411.

Advantages of the Tenant in Common Arrangement

Tenant-in-common ownership, sometimes called tenancy-in-common, is a method of holding title to property involving multiple owners. When a tenancy-in-common arrangement is created, each individual owner, called a “co-tenant” or “co-owner,” owns an undivided interest in the property.

Typical Tenant-in-Common Interest

tenant in common investment
Typical tenant-in-common agreements involve many individuals who each own a fractional interest in a property.

A typical tenant-in-common (“TIC”) interest involves a number of parties, generally unknown to each other, who each own an undivided tenancy-in-common interest in real property.

There can be any number of co-owners. Ownership of a TIC allows the investor to own a fractional interest in a property that is typically investment-grade and professionally managed.

Why Tenant-in-Common?

One advantage of TIC investment is the potential for tax-free exchange treatment. In 2002, the IRS issued Revenue Procedure 2002-22, which states that a taxpayer can use a TIC investment, if properly structured, as either relinquished property or replacement property in a qualifying like-kind exchange.
(I covered like-kind exchanges in my previous post, “Understanding IRC Code Section 1031 and Why You Should Care.”)

The relationship among TIC owners is generally controlled by a tenancy-in-common agreement (“TIC Agreement”). Decisions to sell, borrow, or lease a property, or hire property management, are typically controlled by the TIC Agreement.

Additional Advantages

There are other benefits to TIC ownership, including professional property management, diversification, appreciation, and predictable cash flow.  Investors may counter that they can receive these benefits in a partnership structure; however, a partnership interest is considered personal property and cannot be exchanged. (The Internal Revenue Code specifically prohibits the exchange of partnership interests.) However, an LLC or partnership can do a 1031 exchange on the entity level.  This means the partnership relinquishes the property and the partnership purchases a replacement property.

If you are buying a property with another person or persons, KRS CPAs can help you set up a tenancy in common. Give us a call at 201-655-7411 or email [email protected].